Cash Flow Estimation and Capital Budgeting 1

Cash flow estimation is a necessary step
for assessing investment decisions of any kind.

In this DCF model, the major step of valuation is
the estimation of future cash flows. The most
important variable in estimating cash flows are
the firm’s future sales growth and profit
margins.
Cash flow analysis offers critical information

on the financial health of a company.
Cashflow should be measured on an incremental basis
Cashflow should be measured on after-tax basis
All the indirect effects of a project should be included in the cashflow

calculations.
Sunk cost should not be considered when evaluating a
project
The value of resources used in a project should be measured in terms of their
opportunity cost
is a way for companies to make smart
investment decisions. It's like planning
how to spend your money on things
that will help your business grow.
These investments can include buying
stuff like land, buildings, machinery, or
even research and development.
Capital Budgeting - is the process by
which investors determine the value of
a potential investment project
(Investopedia, 2023).
Capital budgeting requires huge investments of funds, but Capital expenditure is long-term in nature or permanent in
the available funds are limited, therefore the firm before nature. Therefore financial risks involved in the investment
investing projects, plan are control its capital expenditure. decision are more. If higher risks are involved, it needs
careful planning of capital budgeting.
The capital investment decisions are irreversible, are not Capital budgeting not only reduces the cost but also increases
changed back. Once the decision is taken for purchasing a the revenue in long-term and will bring significant changes in
permanent asset, it is very difficult to dispose off those the profit of the company by avoiding over or more investment
assets without involving huge losses. or under investment.
Capital budgeting is a valuable
tool because it provides a means
for evaluating and measuring a
project's value throughout its life
cycle. It allows you to assess and
rank the value of projects or
investments that require a large
capital investment (Investopedia,
2023).
NPV is the difference between the present value of cash
inflows and the present value of cash outflows over a
specific time period. It takes into account the time value
of money and helps determine the profitability of an
investment or project. A positive NPV indicates that the
investment is expected to generate a profit, while a
negative NPV suggests a potential loss.
Formula:
NPV = Net Present

Value
CF = Cash Flow
r = rate of return
n = number of period
Example:
Calculate the net present value of a project
which requires an initial investment of
$243,000 and it is expected to generate a net
cash flow of $600,000 each year for 5 years.
Assume that the salvage value of the project is
zero. The target rate of return is 12% per annum.
•
•
Formula:
Example:
You are considering a project
which requires an initial
investment of $24,000. The
project will produce cash
inflows of $8,000, $9,800,
$7,600 and $6,900 over the
next four years, respectively.
What is the net present value

of this project if the required
rate of return is
12%?
•
•
Payback refers to the length of time required for an
investment to recover its initial cost. It is a simple
measure that calculates the period needed to recoup the
investment through expected cash inflows. The shorter
the payback period, the more favorable the investment is
considered.
Formula:
Example:
The cost of the machine is
$28,120, and it is expected to
bring the company a net cash
flow of $7,600 per year for the
next fifteen years of the
machine's useful life.
Cost of Investment = $28,120
Annual Net Cash Flow = $7,600

Note: The payback period is the time it takes for the cumulative cash
inflows to recover the initial investment.
A shorter payback period has lower risk, while a longer payback
period has higher risk.
Formula:
Example:
A project has an initial cost of
$199,000. The project produces
cash inflows of $46,000,
$54,000, $57,500, $38,900 and
$46,500 over the next five years,
respectively.
What is the payback period for

this project? Should the project
be accepted if the required
payback period is 3 years?
Years before full recovery = 4
Unrecovered cost at the start of the year = 2,600
Cashflow during the year = 46500
Similar to the payback period, the discounted payback
period takes into account the time value of money by
discounting the expected cash inflows. It measures the
time required to recover the initial investment in present
value terms, considering the discount rate. The
discounted payback period provides a more precise
estimate of the investment's recovery time.
Formula:
Example:
A project that cost $5,000
with 1,000 annual cash
flow. Assuming the
company uses discount
rate of 10%, the
discounted payback
period is:
Note: A shorter discounted payback value

indicates lower risk, and the one with the
shorter payback value should be chosen.
Formula:
Example:
A project has an initial cost of $200,000 and produces cash inflows of
$86,000, $93,600, $42,000 and $38,000 over the next four years,
respectively.
What is the discounted payback period if the discount rate is 10%?
Should this project be accepted if the required discounted payback
period is 3 years?
Years before full recovery = 3
Initial Cost = 200,000
Cumulative Discounted Cash Flow = 187,092.41
Cashflow during the year = 25,954.51
Note: A shorter discounted payback value indicates

lower risk, and the one with the shorter payback value
should be chosen.
The AAR calculates the average profit of an investment
over its lifespan, expressed as a percentage of the
average investment amount. It is a relatively simple
measure that focuses on accounting profits rather than
cash flows. A higher AAR indicates a more profitable
investment.
Formula:
Example:
A project has an initial cost of $134,000 for equipment. This
equipment will be depreciated using straight line
depreciation to a zero-book value over the four-year life of
the project. The project is expected to produce annual net
income of $4,700, $5,100, $5,800 and $6,500 over the four
years, respectively.
What is asked?
• What is the average accounting return (AAR)?
• Should this project be accepted if the required AAR is 8%?
IRR is the discount rate that makes the net present value
of an investment equal to zero. In other words, it is the
rate of return at which the present value of expected cash
inflows is equal to the present value of cash outflows. The
IRR represents the effective interest rate earned on an
investment and is used to assess the attractiveness of an
investment opportunity. If the IRR is higher than the
required rate of return, the investment is considered
favorable.
Formula:
Example:
You are considering a project with an initial cost of

$48,500. The project has a five-year life and produces cash
inflows of $9,800, $12,200, $12,850, $13,200 and $13,600
over the five years, respectively.
What is asked?
• What is the internal rate of return on this project?
• Should this project be accepted if the required rate of return
is 8%?
•
•
The Profitability Index (PI), also known as the Benefit-
Cost Ratio (BCR), is a measure that calculates the ratio of
the present value of cash inflows to the present value of
cash outflows for an investment. It helps assess the value
created per unit of investment. A PI greater than 1
indicates a positive net present value and suggests a
profitable investment. The higher the PI, the more
attractive the investment opportunity.
Formula:
Example:
The project you are considering has cash inflows of

$4,800, $6,400, and $8,200 over the three-year life of
the project. The initial cash requirement is $13,600.
What is the profitability index if the discount rate is
9%?
What is asked?
• PI=?
•

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Cash flow estimation is a necessary step

for assessing investment decisions of any kind.

Cash flow analysis offers critical information

Cashflow should be measured on after-tax basis

All the indirect effects of a project should be included in the cashflow

NPV = Net Present

What is the net present value

Cost of Investment = $28,120

Annual Net Cash Flow = $7,600

What is the payback period for

Note: A shorter discounted payback value

Note: A shorter discounted payback value indicates

You are considering a project with an initial cost of

The project you are considering has cash inflows of

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